I hope that my articles provide the above to some investors who feel they need it!
Back to April Update Part II
If you are new to this series you will likely find it useful to refer back to the original articles, all of which are listed with links in this instablog. It may be more difficult to follow the logic without reading Parts I, II, IV and X. In Part I of this series I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction.
I have stressed in previous articles of this series that I generally do not predict recessions or bear markets. Recessions and market corrections are just part of the investing experience. They occur when we least expect them. This is why I hedge. I began in 2014 by using about 1 ½ percent of the value of my portfolio to hedge against a potential portfolio loss of 30 percent or more. Then, as I was able to capture some sizable gains from a few positions, my cost for that first year was reduced to less than one percent of my portfolio. It amounts to an inexpensive form of insurance and provides me with peace of mind. Last year my gains were much more significant and I was able to offset all of my hedging cost for 2015, the remaining costs from 2014 and have plenty left over to extend my hedge well into 2016. So, now I am basically working with house money, so to speak, and my portfolio remains fully hedged against loss. For a full accounting of the results from last year and a summary of 2014 and 2015 please refer to this article. Within the series I have only listed one option contract for May 2016 expiration and it is time to sell that position as the contract expires this Friday, May 20, 2016.
Taking a Healthy Profit
On December 28, 2015 I published this article in which I listed L Brands (NYSE:LB) as one of my favorite candidates for my hedging strategy. I recommended buying the May LB put option with a strike price of $85 for a premium of $2.50. The stock for LB was then trading at $96.82. Today, Thursday May 19, LB stock is trading just under $61 (at about 1:30 p.m.) and the May LB $85.50 put option contract will fetch $22.90. Since there is no open interest on the $85 contract, I must assume that either no one bought the $85 strike at the time of my article, those who did have already sold, or that some may have gotten into the $85.50 strike contract at or near the recommended premium.
In any event, if you own any May LB put options at $85.50 and bought them for $3.00 or better (which was about what became available shortly after that article was published), you should now sell those contracts for the current bid price of $22.90 for a gain of 663 percent. Personally, I did not buy the $85 strike but was fortunate enough to enter the $85.50 strike contracts in early January for a similar strike.
If you own, like I do, the August LB put options at lower strikes I suggest holding onto those positions as I expect the doldrums of retail to continue well into summer. Inventories are extremely high at retailers and that means further discounting leading to reduced margins until the excesses can be worked off.
Discussion of Risk
I want to discuss risk for a moment now. Obviously, if the market were to rally higher beyond January 2017 all of our option contracts that we have open could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions, except for those gains we have already collected. But it is one of the potential outcomes and readers should be aware of it. The longer it is before the next recession, the more expensive the insurance may become. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible.
Because of the uncertainty in terms of whether the market will turn into a full blown bear or regain the high ground and the risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as two percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than three percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total before a major market downturn has occurred. When the bull continues for longer than is supported by the fundamentals (which is where we are today in my opinion), the bear that follows is usually deeper than it otherwise would have been. In other words, at this point I would expect the next bear market to be more like the last two, since the market has, in my opinion, defied gravity until now. Anything is possible but if I am right, protecting a portfolio becomes ever more important.
As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.
For those who would like to learn more about my investment philosophy please consider reading " How I Created My Own Portfolio Over a Lifetime, or for those who would rather listen to a podcast on the same subject, you may want to consider my interview by IITF.com which can be found here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I hold put option positions in L Brands.